A Risk vs Reward Analysis
There are several products in the market that are considered “buy and hold”. These products typically have some characteristic that provides the justification for this consideration. For example, if a product has a surrender fee, it is typically considered a “hold” until the surrender fee has expired. A surrender fee is a fee associated with withdrawing funds in advance of the investment’s maturity date.
At Fountainhead, we do not view these products as default “hold” products. The first important item to note is that surrender fees are not necessarily a method by the product creator to extract additional fees from a client. These fees may be justified due to a lack of liquidity or some other quality relating to the underlying securities.
Second, regardless of the product creator’s underlying reason for the surrender fee, why wouldn’t we regularly analyze to ensure the product is still appropriate for the client? After all, both the characteristics of a strategy as well as a client’s needs are dynamic and necessitate constant monitoring and potential adjustment!
For example, several of our clients have investments in annuity products that provide a level of downside protection and upside performance on major market indexes (e.g., the Dow Jones Industrial Average or S&P 500). The product has become quite popular in the market place based on the ability to match a relatively defined exposure on behalf of the client.
Upon setting the planned exposure on behalf of the client, downside protection can be toggled up or down which will result in less or more upside participation. Protecting on an initial 10% decline over a three-year period may allow for 35% upside potential on the S&P 500 while protecting on an initial 15% decline may result in a potential 25% upside.
These products have surrender fees that range from 3% to 9% based on the individual company’s policies and when the client wishes to exit the strategy (the earlier you withdraw your funds, the more costly the surrender fee).
However, it would be a disservice to the client if we simply ignored the product until maturity due the surrender fee. The following is an example of one scenario where we thought prudent to explore exiting a position despite a 5% surrender fee:
Approximately four years ago, the client purchased a product with a five-year maturity date. The investment performance was linked to the S&P 500 (the major market index comprised of the USA’s top 500 companies) and provided full absorption of a stock market decline if the market declined 10% or less from purchase level over the duration of the five-year contract.
In exchange for the loss protection, the client can participate in the upside growth of the stock market, but only to the extent that the market grows 68% over that time, but not more. This limitation is known as “the cap” because the 68% is where you quite literally hit a ceiling on your return.
When analyzed recently, the price of the S&P 500 had increased 65% during the 4 years our client owned the contract. The characteristics that the product now provided the client were very different than inception.
For one, since the loss absorption feature only triggers when the market declines below the original starting point, the client would now need to lose all 65% of its gains over the last four years before the product would provide ANY of that coveted loss absorption.
Furthermore, the current increase of 65% is very close to “the cap” of 68%. This results in a scenario where the client is limited to gain only 3% more over the final year of the contract (65% 68%) but is exposed to losing as much as 65% of the gains achieved from the first four years before any losses can be absorbed by the financial institution.
After reviewing the data, the client decided they wished to surrender the contract early and pay the surrender fee and other associated costs to exit (“exiting fees”). Their rationale was that the costs incurred to exit were reasonable to incur given the minimal upside potential and full downside risk the client was currently exposed to within the product.
The exit value for the client equated to approximately 11% per year of growth. In this example, it was the product characteristics that shifted materially from inception, not the client’s goals. The ability to analyze the product continuously and properly in context of the original intent and client goals allowed for the flexibility to recognize that a reset of exposure to better align with initial goals of a level of downside protection with modest upside participation was warranted. It also allowed for the understanding that the return characteristics were sub-optimal at the moment of analysis further pointing to a need to exit.
If truly considering all options, there is no such thing as a “buy and hold” product, at least at Fountainhead. External fees are either sunk costs or inputs and are analyzed along with all other elements of a position.
Ultimately, what we care most about is answering two specific questions: “Is the product still properly working on behalf of our client?” and “Is the exposure still appropriate for the client?”. Sometimes repeating simple questions leads you to find the new best answers.
 Note that these products are based on the price performance of the S&P 500, not the total performance resulting in giving up the dividend which is currently a touch below 2% annually.